Farm Management

Introduction to Farm Management

 Farm business management has assumed greater
importance not only in developed and commercial
agriculture all round the world but also in developing
and subsistence type of agriculture.
 A farm manager must not only understand different
methods of agricultural production, but also he must
be concerned with their costs and returns.
 He must know how to allocate scarce productive
resources on the farm business to meet his goals and
at the same time react to economic forces that arise
from both within and outside the farm.
 The need for managing an individual farm arises
due to the following reasons:
 1. Farmers have the twin objectives ,maximization of farm
profit and improvement of standard of living of their
families.
 The means available to achieve the objectives, i.e., the
factors of production, are scarce in supply.
 The farm profit is influenced by biological, technological,
social, economic, political and institutional factors.
 The resources or factors of production can be put to
alternative uses.
 3. Farm management is concerned with resource
allocation.
 On one hand, a farmer has a set of farm
resources such as land, labour, farm buildings,
working capital, farm equipments, etc. that are
relatively scarce.
 On the other hand, the farmer has a set of goals
or objectives to achieve may be maximum family
satisfaction through increasing net farm income
and employment generation.
 In between these two ends, the farmer himself is
with a specific degree of ability and awareness.
 This gap is bridged by taking a series of rational
decisions in respect of farm resources having
alternative uses and opportunities.
 The study of farm management would be useful
to impart knowledge and skill for optimizing the
resource use and maximizing the profit.
 The following definitions would throw light on the
meaning of farm management:
 DEFINITIONS

 Farm means a piece of land where crop and

livestock enterprises are taken up under a
common management and has specific
boundaries.
 All farm management economists can be
categorized into three groups on the basis of
whether they consider farm management as an
art, science or business.
The first group of farm management economists
comprising of Andrew Boss, H.C.Taylor and L.C.

 Gray viewed farm management as “an art of

organization and operation of the farm successfully as
measured by the test of profitableness”.

The second group comprising of G.F. Warner and J.N.

Effersen considered farm management “as a science of
organization and operation of the farm enterprises for
the purpose of securing the maximum profit on a
continuous basis”.
The third group of economists like L.A.
Moorehouse and W.J. Spillman defined farm
management “as a study of the business phase
of farming”.
The most acceptable definition of farm management is
given below:

Farm Management is a science that deals with the

organization and operation of a farm as a firm from the
point of view of continuous maximum profit consistent with
the family welfare of the farmer.
Thus, in an environment where a farmer desires to
achieve objectives like profit maximization and
improvement of family standard of living with a limited stock
of factors of production which can be put to alternative
uses, farm management in an essential tool.
 FARM MANAGEMENT DECISIONS

Farmers must be able to take appropriate

decisions at appropriate time

Incorrect judgement and decisions would

result in the failure of execution of farm plan
and in turn economic loss
The first method of classifications is according to the
following criteria: a) Importance, b) Frequency, c)
Imminence, d) Revocability and e) Alternatives
available. Each of the above criteria is discussed
briefly.

a)Importance: Farm management decisions vary as to

the degree of importance measured generally through
the magnitude of profit or loss involved.
For example, a decision to engage in
poultry is relatively more important than a decision
regarding the type and location of poultry shed.
b) Frequency: Many decisions assume
importance on the farm because of their high
frequency and repetitive nature.
The decision about what and how much
to feed to the dairy animals is made more
frequently than that regarding the method or
time of harvesting of paddy.
c) Imminence: It refers to the penalty or cost of
waiting with respect to different decisions on
the farm.

Experience shows that while it pays to act

quite promptly in some cases, postponement is
necessary in other cases till the required
complete information becomes available.
For example, the decision to harvest paddy is
much more imminent than a decision about
buying a tractor.
d) Revocability: Some decisions can be altered
at a much lower cost as compared to others.

For example, it is relatively easier to

replace paddy with groundnut, which perhaps
becomes more profitable, than to convert a
mango orchard into a sugarcane plantation.
e) Alternatives available: The number of
alternatives can also be used for classifying
farm management decisions.

The decisions become more complicated as

the number of alternatives increase. For
example, threshing of paddy can be done
manually or with thresher.
But its existence also presupposes the
existence of property, including natural physical
things, some of which exist as systems.

To this extent, as a social system the law of

property is dependent on or subordinate to
natural systems.
Classification of decisions based on the
above criteria is not mutually exclusive and is
changing from individual to individual and from
place to place for the same individual.
ii) The second method classifies farm management
decisions into:
a)what to produce?
b)b) when to produce?
c)c) how much to produce? and
d)d) how to produce?
The farm manager should choose the enterprises
based on availability of resources on the farms and
expected profitability of the enterprise.

This is studied through product-product relationship.

Once the farmer decides on what to produce, he must

also decide on when to produce, as most of the
agricultural commodities are season bound in nature.

Then, he should decide how much of each enterprise

to produce, since the supply of agricultural inputs is
limited.
This can be studied through factor-product
relationship.
In order to minimize the cost of production, i.e.,
decisions relating to how to produce, factor-factor
relationship has to be studied.
The farm manager should also take marketing
decisions like
a) what to buy?
b) when to buy?
c) how much to buy?
d) how to buy?
e) what to sell?
f) when to sell? G
g) how much to sell? And
h) how to sell?
 Factors Influencing Farm Management
Decisions:
Farm management decisions continuously
undergo a change overtime because of the
changing environment around the farm, farmer and
his family.

The factors which influence the decision

making process are:

4-8 Economic factors like prices of factors and

products.
b) Biological characteristics of plants and animals.
c) Technological factors like technological
advancements in the field of agriculture and
suitability of different varieties and farm practices to
varied agro - climatic conditions.

d) Institutional factors like availability of

infrastructural facilities which include storage,
processing, grading, transport, marketing of inputs
and outputs, etc, government policies on farm
practices, input subsides, taxes, export and import,
marketing, procurement of produces and so on.
e) Personal factors like customs, attitude,
awareness, personal capabilities and so on.

One or more changes of the above categories in

the environment around the farmer may cause
imperfections in decision-making.

The process of decision making, therefore, has to

be dynamic so as to adjust in such changes.
 Decision Making Process
Every farmer has to make decisions about his
farm organization and operation from time to
time.
Decisions on the farms are often made by the
following three methods:

a) Traditional method: In this method, the

decision is influenced by traditions in the family
or region or community.
b) Technical method: In this method, the decisions
require the use of technical knowledge. For example,
a decision is to be made about the quantity of nitrogen
requirement to obtain maximum yield of paddy.

c) Economic method: All the problems are considered

in relation to the expected costs and returns. This
method is undoubtedly the most useful of all the
methods for taking a decision on a farm.
 Steps in Decision Making

The steps in decision - making can also be

shown schematically through a flow chart.

The important steps involved in the

decision-making process are formulating
objectives and making observations, analyses
of observations, decision-making, action
taking or execution of the decisions and
accepting the responsibilities.
The evaluation and monitoring should be done at
each and every stage of the decision making
process.
Functions of a Farm Manager:
Some of the major areas, which form the subject
matter of farm management, are listed below:

a)Farm Management Functions: The major farm

management functions are:

1)Selection of enterprises.

2) Organization of agricultural resources and farm

enterprises so as to make a complete farm unit.
3) Determination of the most efficient method of
production for each selected enterprises.

4) Management of capital and financing the farm

business.

5) Maintenance of farm records and accounts and

determination of various efficiency parameters.

6) Efficient marketing of farm products and

purchasing of input supplies.
7) Adjustments against time and uncertainty
elements on farm production and purchasing of
input supplies.

8) Evaluation of agricultural policies of the

government.
b) Farm management activities are differently
viewed by different authors. Farm managers are
generally responsible for taking up technical,
commercial, financial and accounting activities.

These activities are elaborately discussed below:

 ECONOMICS IN FARM MANAGEMENT

Economics is about wealth, that is the use of

often scarce resources to produce and exchange
goods in order to create wealth
Farmers have limited amounts of land, labour,
money (or credit) for inputs and other resources to
use on their farms
Farm management is about making decisions
regarding use of the resources available
Wealth is created by putting resources together.
How farmers use their resources affects how
much wealth they can create.
An example of assessing resource utilization

A farm family have chickens. Should they eat the

chickens or should they look after them and have
a regular supply of eggs? If they decide to keep
the chickens for their eggs, should they eat the
eggs or should they sell the eggs? Which is the
best use of their resources?
Learning about some of the key economic
concepts does help farmers make these
decisions.
These principles lie at the heart of farm
management and knowledge of them is important
for good decision-making.
Learning about some of the key concepts of
economics helps farmers to have greater control
over the processes that influence their wealth.
It can help farmers understand which choices or
decisions will lead them to more wealth.
 Key economic concepts

Factors of production

The main factors of production are natural

resources (land, water, soil, rainfall), labour
and capital.
 Farm enterprises

These are different products produced by

farmers, each of which uses inputs to produce
outputs.

 Farm enterprises can be divided into three

types: competitive, supplementary and
complementary.
 Cost of production

Value of inputs needed to produce crops

or livestock.

Variable costs apply to a specific

enterprise.

Fixed costs generally apply to the farm as

a whole.
 Opportunity cost

When a limited resource is used on one

enterprise it reduces the opportunity to use
it on another.

Also, time spent on a farm enterprise

reduces the opportunity for social or leisure
activities.
Value of production - Money received
from the sales of produce, added to the
value of that consumed or stored.

Gross margin - What an enterprise adds to

total farm profits
(Gross margin = Value of production – Variable costs).
Farm profit - Money left over after variable
and fixed costs are paid.

Net farm family income - Farm profit after

taking into account cost of family labour
used to generate it
Cash flow - Difference between money received
(inflows) and money paid out (outflows).(Although
a farm may be able to make a profit, there may be
times of the year when it runs out of cash and is
then unable to purchase inputs and materials).

Substitution - Replacing one method of

production with another that is more efficient in
terms of labour, time or money
Efficiency - return to scarce resources
The wise use of resources available to the farmer.

Risk - Weather and diseases affect farm yields.

Changes in market prices and input prices vary.

Farmers must take these and other risks into

account.
 FACTORS OF PRODUCTION

Factors of production are the resources

needed to produce something. The main
ones are:

natural resources
labour
capital
 Natural resources

Natural resources are what can be called

“gifts of nature”

They include land, water, soil and rainfall

These are resources that are not the

result of what is called “human
effort”
 Land
A typical farm family may own or rent some land
for cultivation

The farmer’s homestead may also have

land around it that could be used for growing food,
fruit or forage crops

Many farmers have the right to use what

is called “communal land”

This is usually land used as a forest or for cattle

grazing
 Water

Farmers have access to water directly from

rainfall and from springs, dams, wells and rivers or
from water collected from rainfall

This water may be on the land used by the

farmer or it may be from a communal source
 Labour
Labour is the work of farmers, their families and hired
labourers.
This is human effort and it is needed on all
farms
Farmers may have three different sources of labour: the
farm family (family labour), hired labour and labour
provided through cooperation between members
of the community
A farmer may use any or all sources of labour on the
farm, depending on the situation

The total effort from labour is made up of people, skill

and time available
 Capital
Land and labour can often be made more productive if
land is improved

Sometimes land is cleared, cultivated, irrigated or

drained

The supply of water can be increased by the construction

of dams, storage tanks and canals

These improvements on the land require capital

Capital is simply a resource that is produced as a result

of human effort
Capital includes buildings, dams, roads and machinery
as well as inputs and materials

It can be divided into two types: durable and working

capital

Durable capital is made up of items that last for a long

time, such as machinery, equipment and buildings

Working capital consists of the money used to buy

stocks of inputs and materials, such as seed and fertilizer,
that are generally used within a season, as well as other
items of expenditure paid in advance of income earned,
such as wage bills, maintenance and repairs.
Capital is used by all farmers, but small-scale farmers
often have very little cash capital.

Most of the capital found on their farms is in-kind.

This includes livestock, tools and equipment, buildings

and land improvement measures as well as stocks of
seed, fertilizer and animal feed.
Capital is often referred to as assets

Assets can also be divided into CASH and PHYSICAL

forms of capital
 FARM ENTERPRISES
Most farmers have a range of different products that they
can produce

These might include crops such as paddy, maize, cotton

and groundnuts as well as cattle, poultry, sheep and goats

The different products are known as farm enterprises

Each farm enterprise uses inputs to produce outputs

Inputs are the things that go into production: the use of the
land, farm and family labour, hired workers, seed for crops,
feed for animals, fertilizers, insecticides and other supplies,
tools and implements, draught animals and tractors.
Outputs are the crops and livestock products themselves

They are the products of the enterprise

The relationship between inputs and outputs determines

what the farmer produces

Economists call this relationship the production function.

Farm enterprises can be divided into, competitive

supplementary and complementary
 Competitive enterprises
Enterprises are said to compete when they use the
same resources

For example, if a farmer doesn’t have enough labour

to harvest two different crops at the same time, the
output of one crop can only be increased if the other
is reduced.
 Supplementary enterprises
Enterprises supplement one another when they use
resources that might otherwise not be used

For example, if a farm is located in an area that has early

and late rains it may be possible to grow one crop to make
use of the early rains and a second crop that makes use of
the late rains

The resource, water, is not left unused

The two crops do not compete for water because they

require the resource at different times of the year

These two enterprises are supplementary.

 Complementary enterprises
Enterprises complement one another when they interact
in a supportive way, such as where poultry produces manure

The manure can be applied as a fertilizer to crop enterprises

 Similarly, poultry or animals can be fed the crops produced

This relationship between the livestock and crop enterprises

shows that the two are complementary.
ENTERPRISE COMPARISONS

Competitive enterprises use the “same” resources

On her three hectares of land a farmer grows maize, beans

and pumpkins which use many of the same factors of
production

Introducing a new crop will mean that one or more of her

current enterprises will have to be reduced or not planted at all

These enterprises are competitive.

Supplementary enterprises use “otherwise unused”
resources

The farmer allows her cows to graze on land she cannot use
for growing crops

She does not feed her chickens excessively and allows them
to scavenge for feed so they do not use other food resources
that may be used profitably elsewhere on the farm

These are supplementary enterprises.

Complementary enterprises “support one another”

The farmer collects chicken and cow manure to use as

fertilizer on her beans and pumpkins

She also uses maize harvest residues and by-products to

feed her chickens and cows

These enterprises are complementary.

 COST OF PRODUCTION

Cost of production refers to the value of the inputs

involved in the production of crops and livestock

For the purposes of farm management it is useful to

divide costs into two kinds: variable costs and
fixed costs.
Variable costs

Costs vary according to the size of the enterprise,

the amount of inputs used, and the yields achieved
If the area of land under a particular crop increases
or more inputs are applied, then variable costs also
increase
If less land is planted or fewer inputs are used, the
variable costs decrease.
Examples of variable costs

A farmer has to hire labour for weeding and harvesting

If the farmer increases the area that needs to be

weeded or increases the number of times the land is to
be weeded, the cost of hired labour will also increase

Similarly, the amount of labour needed for the harvest

is linked to the yield.
If a low yield is attained the amount of hired labour
at harvest time will also be low

If a high yield is attained the labour costs will be

higher

The same is true of other inputs

If the farmer decides to increase the amount of land

planted to maize, the amount of seed and fertilizer
applied will increase, so increasing the farmer’s
costs.
 Fixed costs

Costs which can be termed fixed usually apply to a

specific enterprise and they do not vary with changes
in production

These costs include the costs of using a tractor,

farm equipment and draught livestock as well as
payment for permanent labour.
Examples of fixed costs

A farmer has a small storeroom for fertilizer, seed,

animal feed and farm tools

 Any costs associated with the storeroom (e.g. maintaining

or cleaning it) are shared by all of the farmer’s enterprises

These costs are not affected by production or yield

 Whether production is increased or decreased, or the yield

is high or low, the costs are fixed
It would be difficult to divide such costs and allocate them to the
farmer’s individual enterprises

Concerning draught power and equipment, most of the costs of

keeping a tractor, draught cattle and farm equipment remain the
same whether the item is or is not fully used

A tractor can be used for a mix of farm operations, cultivating a

crop, transporting feed for livestock and even transporting people to
town (although this is a very expensive form of transport)

The cost for different activities cannot be easily allocated to any

one enterprise
Portions of fixed costs, such as fuel or hours of draught animal
use, can be allocated between enterprises but this usually requires
good information, which is often unavailable to smallholder farmers

For the most part, fixed costs only become important in more
commercialized agriculture when farmers have mechanized
equipment

 Smallholder farmers usually have few fixed costs

Most often they need not worry about allocating fixed costs
between enterprises

Practically all their costs are variable costs.

 Opportunity cost
There is another cost that is often overlooked but is
important in economics: opportunity cost

We have mentioned before that, because resources are

limited, when a decision is made to allocate resources
something else has to be given up

If a farmer spends money on buying tools, he or she will

have less money to spend on other items

In all aspects of life, having one thing often means going
without another

And there is a cost to giving something up.

An example of an opportunity cost

A farmer grows maize and earns P5,500. If the farmer

had grown tomatoes instead of maize earnings may have
been P9, 500 The opportunity cost of growing tomatoes is the
P4, 000 that was lost (given up) from not growing maize.

In both situations the farmer would have made money, but
the point is that more money would have been made from
tomatoes than from maize.
The concept of opportunity cost can also be applied to
labour

The cost of hired labour is very easily measured by the

wage paid.

But how is the time of farmers and their families

valued? It is done by deducting the value of the time they
are absent from other activities.

As an example, a farmer works part-time in town and

decides to take a day off in order to work on the farm.
The farmer will be giving up a day’s wages from the
other job.

This cost is just as real as paying a hired labourer to

do the work.

Another example concerns time available to farmers.

Where time is spent on a farm enterprise it is not

available for social or leisure activities so there is an
opportunity cost also associated with non-business
activities.
There is also an opportunity cost of capital

If a farmer allocates scarce financial resources to a

farm enterprise, is this the best use of that money?
Perhaps the farmer would have made more money
by leaving the cash in the bank and earning interest.

Perhaps the satisfaction would have been

maximized by adding a new room to the family
house.
 VALUE OF PRODUCTION
Once a crop has been harvested, the farmer (and
family) can do three things: sell it, consume it, or
store it

The value of production is the money received from

the sale of produce together with the value of
produce that is consumed and stored (i.e. unsold
produce)

It is sometimes referred to as the “value of output”

The value of sales is very easily measured by the
amount of money the farmer receives

This is calculated as the quantity of production sold

multiplied by the price that the farmer receives

Value of production sold =

Quantity sold x Sales price
As noted before, the value of production also includes
the value of unsold produce

This is produce consumed by the farm family or stored

A convenient method of valuing produce is by using the

market price for which the produce could have been sold

A more precise way to measure the value of food

produced
and consumed by the family is to ask: “What would we
have had to pay for the food if we had not produced it?”
However, in rural areas there is little difference
between selling prices and buying prices and thus the
sales value can be used as a convenient
approximation

Then, the total value of production includes produce

sold, produce consumed by the farmer’s family and
produce stored.

Value of production =
(Quantity sold + Quantity consumed
+ Quantity stored) x Sales price
An example of value of production

After the maize harvest a farmer had 50 bags of maize.

She sold 10 bags of maize at P550.00 each and earned P5,
500. She put 20 in her storage shed; 4 bags for cow feed and
chicken feed; 14 bags for her family and 2 to give to a farmer
friend. If the farmer wanted to know the value of her maize
production, she would have to add together the bags of maize
that she sold in the market, the bags she put in storage and
the bags she gave away, and multiply the total by the market
sales price.

This would be 50 bags x P550.00 = P27, 500

 GROSS MARGIN
The gross margin for a crop or livestock product is
obtained by subtracting the variable costs from its
value of production.

Gross margin =
Value of production – Variable cost
An example of gross margin

A farmer who produces a crop worth P6,000 at

a variable cost of P1, 000 generates a gross margin
of P5, 000 (P6, 000 – P1, 000)

Calculating gross margins is essential when

deciding between different enterprises
If a farmer wants to know whether to continue with a
certain crop or grow another, he or she could compare the
gross margins of the two crops

If a farmer changes enterprises, the fixed costs will

probably not change

But what will change are the variable costs and value of
production

Using a gross margin will help the farmer to see if the

change in enterprise will be profitable or not.
 FARM PROFIT

Farm profit refers to the money left over after the

variable costs and the fixed costs are paid.

Each enterprise has a gross margin, which, as

noted before, is determined by subtracting the
variable costs of the enterprise from the value of
production

The total gross margin on a farm is the sum of the

gross margins of all enterprises.
But, remember, this does not include fixed costs,
which still have to be paid.

The money to pay for the fixed costs comes from

the total gross margin.

Profit =
Total gross margin of all farm enterprises– Total fixed costs
If the amount obtained by subtracting fixed costs from the
total gross margin is positive, there is a profit

If the amount obtained is negative, there is a loss

Because fixed costs do not vary much with changes in

production, it is almost always the case that if farmers can
increase the gross margin on their farms they will also
increase profits

Further, because the smallholder farmer usually has few

fixed costs, the total gross margin is almost the same as
total profit.
 NET FARM FAMILY INCOME
Family labour is an important input for most farmers,
particularly when they are running farming systems that are
only partially or not at all mechanized

Different enterprises require very different levels of labour

input

For example, vegetables require a much higher level of

labour input than maize

Therefore, it is unreasonable to compare the gross margin

of vegetables with the gross margin of maize without
considering the labour required.
In the calculation of the gross margin, the payment for
hired labour is already included in the variable costs

However, in many cases, labour on small farms comes

largely from family sources

In order to meaningfully compare different enterprises, or

technologies relating to the same enterprise, it is necessary
to allocate a cost for this family labour

Estimating the cost of such family labour is done by

valuing what it would cost to hire such labour instead of
using family labour.
Very often, the smallholder farmer should not be as
concerned about increasing profit as about increasing
net farm family income.

This is the farm profit after taking into account the

cost of family labour used to generate it.

After the farm profit is calculated, family labour

costs are deducted.
If the opportunity cost of family labour is low, the net farm
family income could be increased by using family labour more
intensively in farming operations

Farmers often have to decide between hiring a tractor to

speed up cultivation and carrying out farm operations, such as
sowing, weeding and fertilizing manually

In a situation where the family has limited work opportunities

and the opportunity cost of family labour is low, the gross
margins may be increased if much of the work is carried out by
the farm family, rather than by hiring a tractor.
 CASH FLOW
The cash flow is the flow of money into the farm from sales
and the flow of money out of the farm through purchases.

Money received from the sale of farm produce is called

cash inflow.

Money paid out for inputs and materials used is called

cash outflow.

The difference between the cash inflow and the cash

outflow at different times of the year is known as the net
cash flow.
Farmers need to consider their likely cash flow on a monthly or
quarterly basis in order to know whether they will have sufficient
cash when it is required.

If the cash inflow is less than the cash outflow at any particular
time all cash commitments cannot be covered.

Cash flow is not the same as profitability.

Remember, profit is based on the value of production less

the variable and fixed costs.

However, if the farm family consumes a lot of the produce, it is

possible that although the farm is profitable, it may not generate
enough cash to cover its cash requirements.
In the previous example, A farmer who produces a crop worth
P6,000 at a variable cost of P1, 000 generates a gross margin
of P5, 000 (P6, 000 – P1, 000).

When we investigate further, however, we find that the

farmer only sold produce to the value of P500. The farmer’s
family consumed the rest of the produce. Therefore the cash
inflow is P500 and the cash outflow is P1, 000, which means
that the farmer would not have the P1, 000 needed to cover
variable costs unless the farmer had money saved or another
source of income.
 Economics and the market
What is a market?

The place where the exchange of products

for money takes place.
Markets are made up of sellers and buyers.

Key concepts • Market • Seller • Buyer • Price •

What is marketing?

Making decisions about the marketing of farm products

is an important part of farm management.
To make these decisions, farmers need to understand
the market, how it works, how prices are determined.

Key concepts • Marketing • Decision-making • Price •

How does the market work?

Prices are determined by supply and demand.

Supply is the amount
available for sale at a certain price.
Demand is the amount
people are prepared to buy at a certain price.

Key concepts • Supply • Demand • Equilibrium •

How are market prices determined?
(DEMAND)

The price of the product;

The price of substitutes;
Changes in tastes;
Increases in income;
Changes in population;
Future price changes;
Government policy;
Other factors affecting demand

Key concepts • Market conditions •

• Price mechanism •
How are market prices determined?
(SUPPLY)

The price of the product;

The conditions of supply;
Changes in the cost of production;
Change in interest of farmers;
Improved techniques;
Natural resource changes;
Government policy;
Other factors affecting supply

Key concepts • Supply conditions •

• Price mechanism •
Why do prices vary from time to time?

Changes in production and demand

at different times of the year.
Availability of competing products and inflation

Key concepts • Inflation • Seasonality •

Why do some prices change sharply
while others do not?

The nature of the products.

Whether they are essential or non-essential.
Whether there are substitutes.
Length of time involved
in making changes in production

Key concepts • Elasticity • Inelasticity •

Farmers can improve
the price of their products

Premium prices can be attained

if product quality is assured by better
production and post-production processes.
The organization of marketing groups
can also provide negotiating advantages

The key concepts here are quality

and economies of scale.
What is a market?

The word “market” is used in two ways ...

First, it is a place where the exchange of products for money

takes place
Markets are made up of sellers and buyers and their
relationship influences the amount of money received in
exchange for products.
Markets do not have to be physical locations
Exchange can also take place over the telephone and
sometimes, these days, over the Internet
Second, a “market” represents the collective
demand for a product

When farmers understand the market for their

products, it means that they understand the product
that consumers want, how much they want, what
price they are willing to pay and what qualities and
other conditions they demand

We can talk about commodity markets, maize

markets or rice markets in this way
What is marketing?

Making decisions about the marketing of farm

products is an important part of farm management
If farmers are to treat farming as a business they
need to understand marketing and how the market
works
Marketing is a series of exchanges linking the
farmers who produce and sell, and the consumers
who buy. Buyers can take different forms
They include:

Customers who buy for their own use

and their families;
Rural traders who sell the produce to others;
Processors who transform the produce and
then sell it to others;
Wholesalers who buy and sell to retailers;
Retailers who buy and sell to consumers;
Exporters who buy and then sell abroad
Exchange takes place when two sides agree on a price

If they do not agree, no exchange will take place

The exchange mechanism of selling and buying depends on

the price

Understanding how prices are set calls for an understanding

of how the market works

It also calls for an understanding of the factors that affect

supply and demand and cause prices to change

These are all parts of economics

To make a profit, the farmer has to charge a high
enough price to cover more than the costs of
production and marketing

While there may be occasional price falls that

cannot be foreseen, if these costs cannot be covered
in the long run the product should not be produced
 HOW DOES THE MARKET WORK?

In the simplest situation farmers take their products

to markets to exchange them for money

Consumers take their money to markets to

exchange it for products

The market sets the price at which those who want

a product (buyers) can obtain it from those who have
it to sell (farmers)
If supply increases but demand does not increase, the price will
fall

This is often what happens in a market at the time of harvest,

when there is an abundance of produce for sale and prices are low

 Later in the season, when there is less for sale, the price often
increases

If demand increases but the supply does not the price is likely to
rise

Where a product is scarce consumers are willing to pay more for it

This will push up the price

 Fruits and vegetables out of season are examples of scarce

products

When the price of a product increases, profits tend to

increase, which encourages farmers to produce more

On the other hand, if consumers do not want the product, its
price falls and farmers make a loss

 Such a situation may lead to farmers producing less of the

product
 HOW ARE MARKET PRICES
DETERMINED?
As noted in the previous section, prices are determined by
supply and demand. But what does this really mean?

Supply
Normally, the higher the price of a product, the greater the
supply of that product
For example, farmers considering producing tomatoes
would be encouraged by high prices.
If they do produce tomatoes and the price increases, they
would be encouraged to extend the area of land under the
crop
They would also try to grow tomatoes with more or better
quality inputs so that a higher yield could be produced
The table below shows the amounts of tomatoes that could be
supplied at different prices by all producers in the market.

Tomatoes supplied change with the price

Demand

The demand for a product normally rises when its price is

lower

If the market price is high, consumers reduce their

purchases

The table below shows the amount of tomatoes in demand

at different prices

If tomatoes are very expensive, consumers may substitute

other vegetables. If they are cheap, consumers will buy more
Market price

The market price is set at a point where supply and demand

are in balance
Economists call this the equilibrium price
That is the point where the amount in demand matches the
amount supplied

From the tables of demand and supply for tomatoes

the equilibrium price is $6 per kg
This price is the only one where there is
balance between buyers and sellers
At this price 20 000 kg of tomatoes
are both in demand and offered for sale
The equilibrium price can also be plotted as shown below
Suppose that initially the price of tomatoes is set at $8 per kg

At that price 15 000 kg of tomatoes would be in demand and

25 000 kg for sale

There would be an excess supply of 10 000 kg of tomatoes

over the demand

This means that farmers would be left with a surplus that

could only be cleared once the price was reduced

As the price falls, demand gradually expands and supply slowly
contracts until a price of $6 per kg is reached

There is then no need for the price to fall further

Similarly, if the initial price is $4 per kg, 25 000 kg of
tomatoes will be in demand but only 13 000 kg offered for sale

Consumers might even form queues to buy tomatoes

The price would then rise, giving an incentive for farmers to

plant more.

At $6 per kg there is no need for prices to rise further

This is called the price mechanism

 It indicates the wishes of consumers and allocates

productive resources accordingly
 WHY DO PRICES CHANGE?
As we have discussed, prices change depending on
changes in supply and demand

As a result of such changes equilibrium prices and

production levels also change

The farmer needs to recognize such changes and adjust the

farm business to them

The following factors

influence production or supply
 WHY DO PRICES CHANGE?
Seasonality of production
At peak season crops are more abundant than they are
during the off-season.

Changes resulting from climate

Supply also varies from year to year
Changes in production frequently occur as a result of
weather (including rainfall, floods and drought)
Bad or good climatic conditions can decrease or increase
the quantity supplied
Bumper harvests usually decrease prices, poor harvests
usually increase prices
In these cases, the level of production is not affected by
the price of the product but by climatic changes
Production problems
The incidence of pests, diseases and other hazards, such as
fire, can decrease the supply

Change in the cost of production

A decrease in the cost of inputs or the introduction of more
efficient technologies would decrease the cost of production
This makes it possible for the farmer to buy more inputs
and produce more for the same cost of production
As a result more tomatoes could be supplied at the old price
Conversely, an increase in the cost of labour employed
on the farm would have the opposite effect
Improved techniques
The introduction of high yielding varieties could increase the level
of production, resulting in a decrease in product price

Expansion of a crop under cultivation

Farmers may decide to plant more of a crop because of the
prospect of greater profits

Changes in profitability of competitive products

Changes in the profitability of competing products also
cause a change in supply
If cabbage is more profitable than tomatoes, for example,
farmers will gradually shift towards growing cabbages
This change would lead to a decrease in the supply of
tomatoes
For fresh produce, such as vegetables, there are often short-
term fluctuations in supply, sometimes a result of bad weather
which can affect the harvest
There may also be transport disruptions

A change in the number of consumers

Extra people coming into a market can increase demand
Development projects, housing developments and other
programmes often cause people to move to a new area

A change in consumer demand

Changes may occur that make consumers demand more or
less of a product at each price
In other words the level of demand could change
For example, farmers could join together to
promote their sales of tomatoes
They might advertise the good quality, freshness and
availability at times of the year when tomatoes are not usually
found in the market
This may appeal to consumers, increasing demand

An increase in income
As countries get richer there will be a general increase in
income and people will be able to afford new products
As people become richer they tend to reduce their
consumption of staples, such as rice and maize, and increase
consumption of dairy products, fruits and vegetables
A change in the prices of products that are close
substitutes
In some diets spinach may be a substitute for tomatoes
If the price of spinach decreases, consumers may prefer to
purchase it instead of tomatoes
Thus, even though there may have been no change in the
price of tomatoes, the demand could decrease

Availability of competing products

If a wider range of products competing with tomatoes comes
onto the market, consumers have a wider choice
This may lead to a lower demand for tomatoes
However, a lower demand may lead to lower prices, which
could cause demand to increase again
A change in taste
A promotional campaign aimed at persuading consumers to
purchase more of a product could also increase the demand
Similarly, changes in demand may come from changes in
consumer tastes that take place gradually as a result of changes
in diet
Safety concerns
Quickly spreading consumer fears of contamination, as
experienced in the Avian Flu epidemic, can have an immediate
effect of decreasing demand
Expectations of future price changes or shortages
The fear that the price of a product could rise considerably
the following week, for example, because of a planned
transport strike, would motivate people to increase their demand
and stock up
Clearly, this would not happen so much with perishable
products
The relationship between supply and demand and
prices of products is thus extremely complex
A change in the price of one product can affect the demand
and, in turn, the price of an entirely different product
Supply is, however, likely to fluctuate much more than
demand
Market prices are affected more by changes in production
than by changes in demand
Prices are also affected by what is called inflation which is
the general increase of all prices throughout the country
Farmers cannot do anything directly about this
High inflation means that prices rise rapidly
Inflation affects both the price of inputs (seed, fertilizer,
labour) and the price of products
For example, a bag of fertilizer which cost $10 last year may
cost $15 a year later
Similarly a kilogram of tomato that sold for $4 last year may
now be sold for $5
Farmers must be aware of inflation and its impact on farm
input and market prices
 CAN FARMERS SET THE PRICES
FOR THEIR PRODUCTS?
In most cases, farmers do not set their own prices, they
must accept the going price

They are called “price-takers” Farmers generally grow

products that are very similar to those that other farmers grow

If a farmer were to charge too high a price traders and

consumers would refuse to buy the product

By lowering the price, the farmer adjusts it to the market

conditions
However, there are some situations where farmers may be
able to influence the market price
In such situations they are called “price-makers”
This sometimes occurs when there are only a few farmers
producing for a “niche market”
A niche market is a highly specialized market or when
produce is produced at a specific time of the year when
premium prices can be obtained
Being price-makers gives farmers a great advantage
when it comes to negotiating with traders responsible for
distributing their produce
 WHY DO SOME PRICES CHANGE SHARPLY
WHILE OTHERS DO NOT?

Normally, demand increases as prices fall and supply

increases as prices rise
More people are interested in buying products that have a
low price
Farmers are interested in increasing their production to
follow higher prices
However, the supply of some products can be adjusted far
more quickly than the supply of others
For example, the supply of mushrooms and tomatoes can
be increased or decreased quickly in response to price
changes
But other items such as fruit, coffee, tea and milk take
longer to adjust
If the prices of such commodities fall, the decrease in
supply does not come about immediately
First, changes in production would require significant
changes, such as uprooting tree crops
A farmer would need to think through such changes
very carefully
Second, even if the farmer were to make the required
changes, it would take a long time for overall production
to adjust
Elasticity
Elasticity is an economic concept that can help explain
changes in product prices, supply and demand
 It can especially help to explain why changes are more
significant for some products than for others
Different products have different elasticities
When supply or demand change a lot in response
to a change in price, the product is said to be elastic
It is sensitive to price changes
When supply or demand does not change much in
response to a change in price, the product is said to be
inelastic
It is insensitive to price changes
Salt is an example of an inelastic product
The demand for salt would change only by a small
amount if there were a change in the price
There would have to be a very large change to cause a
noticeable change in demand, because salt is both a very
small expense for most families and a product for which
consumption cannot be easily reduced and for which
there are no significant substitutes
On the other hand, vegetables are generally elastic
products When prices change, supply and demand adapt
relatively rapidly
 CAN FARMERS IMPROVE THE PRICE
OF THEIR PRODUCTS?
The quality of a product is as important as supply
and demand in setting the price of produce sold

The quality of a product influences its market price

Consumers pay more for a product that is clean and

free
of dirt, insects and damage

Large eggs sell for a higher price than small eggs

Fat animals sell for a higher price than thin ones

Farmers can improve the quality of crops and livestock
by using better production and post-production practices
Using different breeds or varieties and improving
practices on the farm can increase returns
By improving post-harvest handling practices, farmers
will ensure better quality and could obtain higher prices
However, in order to make these improvements, it is
sometimes necessary to make special efforts that may
involve extra costs
These extra costs have to be covered by an increase in
money received for the higher quality product
Examples are shown on the next page
Actions farmers can take to improve the price of
their products

Improved production
Large eggs and creamier milk, for example, will bring
higher prices compared with small eggs and milk with a
lower cream content
But it is important that farmers consider the extra costs
involved in the production change and compare them
with the extra money that improvement will bring
If the profit is higher than that previously obtained, the
extra effort will be worth it
Organize marketing groups

Farmers acting alone to improve their prices may

not gain
A single farmer improving quality will have to sell to
the same trader as all other farmers
The trader will probably not pay a premium as it will
not be possible to keep good quality and poor quality
produce of different farmers separate
However, farmers working together can often
increase their bargaining power
This helps them to deal with buyers and negotiate
contracts
Marketing groups may also be in a position to offer
their members other benefits such as better market
information
Farmers acting in groups may also be able to
improve packaging
In some countries, working together has
successfully increased prices by using a brand name
or by stressing the geographical origin of the product
Farmers in groups can also work with retailers to
ensure that produce reaches the store quickly and
can thus command a premium for “freshness”
Economies of scale
Scale is used to describe differences in the overall
size of farms or businesses
Economies of scale are achieved when the cost per
unit of production or output marketed is reduced as
the scale of the activity increases
Savings (economies) can be achieved by spreading
costs over a larger scale of operation
They can also be achieved when farmers organize
themselves into groups to buy
Economies of scale
Scale is used to describe differences in the overall size
of farms or businesses
Economies of scale are achieved when the cost per unit
of production or output marketed is reduced as the scale
of the activity increases
Savings (economies) can be achieved by spreading
costs over a larger scale of operation
They can also be achieved when farmers organize
themselves into groups to buy inputs, use capital or
market produce
These group activities can bring about a cost reduction
per unit of inputs purchased or produce marketed
Economies of scale can also come about through
specialization
As output of one product increases there is a
possibility of using more specialized management
and introducing mechanization to take the place of
labour in field operations
Increases in scale of output allow savings to occur
in the time spent on these tasks

The following are examples of some of the

economies that can be achieved when working at a
higher level of marketing and input purchases
Groups of farmers involved in marketing could
share transport arrangements to sell their produce.
This very often results in lower unit costs. If each
individual farmer were to transport produce
separately the amount of produce transported would
be smaller and per unit transport costs would be
higher than those of the collective effort.
Farmers can look for ways to produce collectively.
They could share a tractor, infrastructure for livestock
production or mechanical harvesting.

Collective buying of inputs could also result in

economies of scale. By ordering in bulk, the farmers
would be able to buy their materials at reduced prices
and transport them more cheaply.
 ECONOMICS AND
FARM MANAGEMENT DECISIONS

What decisions do farmers make?

Farmers decide what to produce, how much to
produce and how to produce.
These questions are interconnected and depend on
a better understanding of the relationship between
inputs and outputs.

Key concept • Production function •

How do farmers select products?

Selection of enterprises is often decided by the

existing conditions on the farm.
Increasingly, this requires matching those farm
conditions with the market opportunities.

Key concept • Comparative advantage •

How do farmers allocate resources?

The problems facing the farmer include the inputs

required to maximize profits, the technology to select
and the best way to produce.

Key concepts • Law of diminishing returns •

• Marginal product • Marginal value of production
• Marginal cost • Changes at the margin •
• Optimum level of output • Marginal analysis •
How can farmers assess financial
requirements?

By using the simple principle of cash flow, farmers

are able to assess whether or not they will have
enough money to carry out their plan or if they are
likely to be short of money at any time.

Key concepts • Cash flow • Net cash flow •

• Cumulative balance •
How should farmers cost their assets?

Once durable capital assets (e.g. farm equipment)

are purchased, resources are tied up. Costs are fixed.

Assets can be valued by understanding depreciation

and salvage value.

Key concepts • Depreciation •

• Useful life • Salvage value •
How can farmers assess whether to buy an
asset?

The economic concept used to decide whether or not

to buy machinery or equipment is called the return on
capital. Farm equipment lasts longer than a single
season or year, so decisions must be based on returns
over the long term.

Key concepts • Return on capital •

• Rate of return • Opportunity cost •
How do farmers deal with risk?

Different strategies are needed to cope with risk.

These include using risk reducing inputs; selecting low-
risk enterprises; product diversification; maintaining
input, finance and product reserves; contract farming;
insurance; using market information

Key concepts • Risk • Risk-reducing strategies •

WHAT DECISIONS DO FARMERS MAKE?

Farmers face a number of common problems

What enterprises should they produce? Should their
farming system be specialized or consist of a mixture
of crops and livestock? What should they grow on what
area of land? How should they produce the enterprise
and with what methods and technologies? What
combination of resources should they use in doing so?
 MANAGEMENT DECISIONS

1.Selecting the most profitable combination of

enterprises
2.Determining the most profitable size of the farm
business
3. Using credit wisely
4.Deciding on the most profitable methods and
practices of production
5.Determining the most profitable level of production
6. Timing production
7. Making marketing decisions
8. Determining quality of the produce to be sold
9. Managing risk
There are many factors that affect the decisions
that farmers make, such as the market and the
resources available to them

There are also other, less economic, considerations,

such as the desires and expectations of the farmer’s
family and the need to balance leisure and cultural
activities with productive activities
The farmer must take these into account when
identifying:
the range of varieties that it is possible to grow;
the best market and marketing channels;
the most appropriate time to sell produce;
the best combination of enterprises to have;
the amount of each crop and livestock enterprise that
should be produced;
the amount of resources and inputs that
should be used to produce these products;
the best way of producing for the market;
types of farm practices and technologies to use;
the ways of reducing risks.
Although the list above is long most of these
decisions are interconnected, simplifying the decisions
to be made
The four key decisions to be made by farmers are:
1.What to produce?
2.How much to produce?
3.How to produce?
4.For which market to produce?
All of these questions can be answered by economic principles that
look at the relationship between farm inputs and outputs which we call
the production function.
These decisions cannot be easily separated from
each other because they are all affected by the limited
resources available to the farmer
The decision to be made between different products
and their level of production is affected by how they will
be produced, which, in turn, is influenced by how much
is to be produced
This also affects how much of any resource should
be used
The management problems facing the farmer break
down into two main areas

Discovering the best way of organizing individual

enterprises

Finding the best way of fitting the enterprises

together into the farming system
The first problem requires the farmer to examine the
possible enterprises and decide on the most
appropriate method of production

The second requires the farmer to see how the

enterprises compete and complement one another in
their use of scarce resources
Farmers make decisions through the
following means

Tradition
Some farmers base their decisions on tradition
They may rely on traditional methods of management
and follow established patterns of farming
These methods have evolved over a long time
 For example, a farmer might decide on a cropping
pattern based on a crop rotation that is widely used
Comparison
Some farmers base their decisions on comparison
with other farmers
For example, a farmer may apply fertilizer at rates
used by others cultivating the same crops

Economics
Other farmers may base their decisions on economic
considerations – looking for ways to make profits
They may look at prices of products and their costs of
production and marketing, and then calculate costs and
profit
Often these decisions are taken by farmers without
complete information
Farmers may not know the prices and costs of
products and inputs
In that case profit may be calculated without including
all the cost items and without making a proper
assessment of the value of production
This may mean that farmers will not maximize profits
Farmers’ skills and knowledge of management are
limited
Farm records are not usually kept and information on
prices and costs is often unavailable
Farmers also have difficulty in calculating profits and
assessing how much input to apply
Improvements in farmers’ managerial knowledge must
go hand-in-hand with improvements in technical skills
Better knowledge of farm management should help
farmers to obtain the type of information they need to
make better decisions and to better manage the choices
that they have
HOW DO FARMERS SELECT PRODUCTS?

Selection of enterprises is often decided by the

natural conditions of the farm
Lowland areas of Asia, for example, have a natural
advantage over upland areas for the cultivation of rice
Upland areas with a more temperate climate tend to
be suitable for horticultural production
Dairying has an advantage in areas close to towns
and cities
Even where there are such advantages, farmers
still face choices
For example, a lowland farmer may have to decide
between growing cereals for home consumption or growing
cash crops
Similarly, upland farmers may have to decide between
rearing livestock and cultivating horticultural crops
Farmers often decide by using some of the economic
principles and concepts discussed in this guide without
even knowing it
Selection of enterprises takes place through looking at
supply and demand.
Farmers must have good knowledge of their farms,
including the type of soils and their quality, water
sources and topography as well as an idea of the type
of crops that can be grown
They need to know whether they have sufficient
capital and labour to produce the enterprises and
whether they might require more labour and machinery
at particular times of the year, for example, at harvest
periods
They must also have an idea of the gross margins
that they can earn from the different enterprises
Farmers need to have a sense of what consumers in
the market want

What are retailers or wholesalers willing to pay for the

product? What distribution channels are available?
What is the cost of transport? What crops and livestock
enterprises can fetch high prices? Market-oriented
farming requires matching supply with the demand
The location of the farm in relation to the market and
the transportation network also has an important
influence on enterprise selection
It is often profitable to farm land more intensively the
closer it is to the market
Transportation costs also influence the choice of
what to produce
The closer the farm is to the market the cheaper it is
to transport produce
Transportation costs for products and inputs need to
be included in the gross margin calculation of the
enterprise.
Comparative advantage
There are other questions that farmers face that
relate to the selection of farm enterprises
A common decision concerns whether to specialize in
a single enterprise or whether to diversify the farm
Farmers need to decide to concentrate on only one
or two enterprises or on a number of enterprises
The economic principle for choosing what to produce
is called “comparative advantage”
Very simply, this concept explains how farmers select
those enterprises where profits are likely to be greatest
HOW DO FARMERS ALLOCATE RESOURCES?

Farmers who want to maximize their profits should

make the best use of scarce resources such as seeds,
fertilizers, pesticides, land, labour and machinery
The most efficient use can only be calculated if the
physical relationship between the resource inputs and
the outputs produced are expressed in economic terms
The typical decisions that farmers have to make are:
The typical decisions that farmers have to make
are:

•What quantity of inputs should be used to maximize

farm profit?
•Which technology should be applied?
•Which production method is best used?
These questions are closely related and cannot be
easily separated
Many farm decisions concern how much of a single
“factor” to use in order to maximize profits
How much seed should be used? How much
fertilizer should be applied? How much hired labour is
required? Asking these questions is the same as
asking which level of yield per hectare or how much
weight gain per animal will give the greatest profit.
Highest yield does not always give highest profit

There are many farmers who still talk of the

greatest yield per hectare, the highest production per
animal, and so forth
But the greatest yield is often not the level of
production that generates the highest profit.
The farmer interested in competing in the market
needs to think about gross margins, profit, costs and
returns – not merely maximum yields
Extension officers are trained in production
practices aimed at maximizing production
However, advice given to a farmer that is based
only on production possibilities can work to the
farmer’s disadvantage
Farmers need to understand the impact of
production decisions on profitability
In particular, they need to understand the law of
diminishing returns
Sometimes, producing less is more profitable than
producing more
Law of diminishing returns
The relationship between inputs and outputs rests on the law
of diminishing returns
This law is used to explain how farmers determine the level
of input use needed to maximize profits
It is useful in assessing the level of output that can be
produced either from a single plot or from the entire farm
Variable resources such as labour, water, seed and fertilizer
are applied to a fixed area of land
The law of diminishing returns shows that beyond a certain
yield, the rate of increase in yields decreases, such that the
additional input cost is not compensated by additional yields
The marginal concept
The term marginal is used often in economics
It has the same meaning as additional
It can refer to either output or input
In both cases it can be measured in either physical or financial
terms.
Thus, the marginal product per unit of input means the addition to
total production achieved by adding one more unit of input
Similarly, the marginal value of production means the value of the
marginal, or additional, product
It refers to the value added to the total value of production by
adding one more unit of input
Other common marginal terms include: marginal input and
marginal cost, which refer respectively to added inputs and the cost
of an added input
 HOW CAN FARMERS ASSESS THEIR FINANCIAL
REQUIREMENTS?
We have previously discussed gross margin as a
way of assessing the profitability of an enterprise
This indicates how worthwhile a change in
enterprise may be if planned quantities and prices
are realized
But if a new enterprise is introduced into the
farming system a cash flow analysis also has to be
prepared to assess whether the farm will generate
enough income to cover required expenditures
Cash flow is the flow of money into the farm from
sales and the flow of money out of the farm through
purchases
Cash flow calculations can help farmers assess
whether they will have enough money to carry out
their plan or if they are likely to be short of money at
any time
They enable the farmer to identify the time of the
year when additional financial resources may be
required.
For example, a farmer and his family know that
growing tomatoes on their farm will be profitable, but they
are not sure whether they will have enough funds to finance
the change to tomatoes
They need to find answers to a number of questions:
-How much money is likely to be generated from
producing tomatoes and how much will it cost?
-What enterprises will have to be reduced as a result of
introducing tomato production?
-When will the money be received from sales of produce
and when will money be needed to purchase inputs?
-How would any shortfalls be made up if the amount of
money expected over the year does not cover the
amount needed?
 HOW SHOULD FARMERS COST
THEIR ASSETS?
Farmers often have to make long-term decisions
that, once taken, influence the day-to-day
management of the farm.
As we know, farmers are faced with decisions on
whether to purchase assets such as machinery,
equipment, or livestock and to plant tree crops
Once decisions are taken and money is spent,
resources are committed and the costs become
“unavoidable”
The resources are then tied up on the farm and the
assets are regarded as a fixed cost to the farm.
After capital items such as machinery and
equipment are purchased they immediately begin to
depreciate in value
Depreciation is the loss of value of an asset over
time, either because of it being used or because it will
eventually become obsolete
This is an important factor to consider when looking at
farm costs, as eventually the item will have to be replaced
The following example gives a fairly accurate idea of the cost
to use an item for a year
An example of calculating depreciation

Assume the cost of a plough is P200. It has a life of 5

years. Therefore, each year one-fifth of the cost of
the plough is taken off its value and is treated as an
annual fixed cost. This can be calculated as follows:

Depreciation = Purchase price ÷ Life of item

So, P200 ÷ 5 years = P40 per year, or the amount to

be deducted each year for five years as a fixed cost
As time proceeds there will be a need to replace
an asset
If a farmer buys a capital item but wishes to sell it
before the end of its life span, the value of that asset
is called the salvage value
This is the value that remains unused. If a farmer
sells the asset after two years, even though it has a
life of five years, its salvage value would be the
original price minus the cost of depreciation over the
two years.
 HOW CAN FARMERS DECIDE
WHETHER TO BUY FARM ASSETS?

If farmers want to buy equipment, machinery or

livestock how do they decide what to do? This
decision is different from the questions raised in the
previous sections. Why?
Machinery, farm equipment and livestock last
longer than a single season or year
Therefore the purchase of these items requires
decisions with long-term implications.
The concept that is frequently used in economics
to decide whether or not to buy items of machinery,
equipment or livestock is called the return on capital.
This is the total benefit derived from using the
capital, less the extra costs incurred, including
depreciation, maintenance and repairs.
The return on capital expresses the profit expected
from the investment, which is, in turn, related to the
capital required to give a percentage rate of return on
the capital
The return on capital is calculated as follows:

Rate of return =
Additional annual profit x 100
Cost of investment
First, the amount of capital required has to be
calculated
This is simply a question of adding up the sum required
for livestock, buildings, machinery
or equipment as well as the extra working capital
required for seeds, fertilizer or other inputs
Second, the additional profit is calculated by budgeting
out the additional income against any additional costs
As explained before, the use of gross margins
considerably simplifies such budgeting. One must not, of
course, forget any increase in fixed costs, and costs of
rent, labour, or machinery.
Included also in the additional costs should be an
allowance to cover depreciation in the capital
investment and also any additional maintenance
costs.
 HOW DO FARMERS DEAL WITH RISK?

One of the facts of farming is that the farmer faces

numerous risks because many future events cannot
be known with complete accuracy or certainty
Risk influences the amount of inputs that the farmer
uses as well as their cost
Similarly, there is uncertainty in crop yield and
product prices
As a result, farm profits are always uncertain and
this makes farm operations risky
The more common sources of farm risk can be
divided into the five areas outlined below.
Production risk
Factors that affect the farm yields such as pests or
diseases, poor weather, low rainfall or drought
Marketing risk
Uncertainty about market prices, and the supply of
and demand for products
Financial risk
Availability of funds for development, the possible
need to borrow money and the ability to make
repayment.
Institutional risk
Changes in the provision of services from institutions
that support farming, for example banks,
cooperatives, governments or social organizations.
Human risk
Availability and productivity of farm workers as
affected by accident, illness or death, or political or
social unrest.
Some farmers try to understand risks better and
they may even make plans to reduce them when they
can
For example, in response to a production risk, a
farmer may decide to plant a drought-resistant variety
in order to reduce the risks of low rainfall
The farmer knows that the yield from the drought
resistant variety is likely to be lower than that of a
higher producing variety but does this as a precaution
of the risk of rainfall being low.
As manager of the farm business, the farmer has
to cope with the many different types of risk
Different ways that farmers deal with risk depend
on their personality and the extent to which they are
willing to gamble
Farmers are different, some will take more risks
than others.
The differences in the decisions that farmers take
also depend on their family and financial situation.
For example, if a farmer had financial savings and
the crop failed the family would not go hungry.
The farmer can perhaps afford to take more risk
than a family with no savings.
So the farmer’s decision is complicated and
depends on many factors.
In particular, the higher the demands on the farmer
for cash, the less likely he or she will be to take a
risk.
Risk-reducing strategies

Decisions on what to do vary among farmers but

there are some common ways of dealing with risk.
Some of these may require either a reduction in the
level of production or, alternatively, an increase in the
costs of production over a period of years.
This often means that in order for farmers to
manage risk they may have to give up a part of their
profits in the short term.
Use risk reducing inputs

Buy inputs and materials that better control crop

diseases, pests and use of water, and reduce animal
health problems
Such inputs could include drought-resistant
varieties, pesticides, fungicides and vaccines for
animals
Select low risk enterprises

Choose enterprises that are more stable than

others
For example, those employing reliable crop
varieties or those with well-established channels of
marketing.
Ensure system flexibility

This allows the farmer to shift from one cropping

pattern to another
For example, with some enterprises land used can
be increased or reduced easily without affecting
profitability.
Product diversification

This can increase the number of enterprises on the

farm so that if one fails, the income from others will
be sufficient to keep the farm going
Not all enterprises are likely to fail together.
Maintain input, finance, product reserves.

Farmers can keep reserves such as money,

physical inputs, final products, food
 Such reserves would help protect the farm family
from the risk of price changes
 Food reserves also provide some security against
the risk of crop failure, although storage losses can
be a problem.
Contract farming

Price uncertainty may be eliminated by making

advance contracts with buyers
Farmers may contract with suppliers to provide
inputs at specified prices and also to avoid the risk
that key inputs will be unavailable at critical times
There are, however, risks with contract farming to
be considered
For example, if a cash crop is produced the world
market price may collapse leaving the buyer unable
to honour the contract.
Collecting market information

Good information on seasonal price variations and

changes in prices over the years can be used to plan
when produce should be marketed
The more knowledge farmers have about price
change and the past profitability of enterprises, the
better their position when they plan for the future.
Insurance

Private companies or governments may guarantee

a certain amount of money in the event of a major
catastrophe, in return for an annual premium
Some countries will ensure against crop loss from
hail or hurricane
Farmers must give up a certain amount of their
yearly income in return for this security .
Better management practices

If farmers recognize early on that their crops or

livestock are diseased they can respond more quickly
to spray crops or inoculate livestock
 However, these precautions are likely to increase
costs and reduce profits and such actions would
need to be set against the greater security that is
gained.
Farmers need assistance to ensure that their
produce satisfies the consumer
 This calls for improved farm management skills so
that farmers can better select new opportunities and
have an understanding of how to deal with the market
The principles of economics as discussed in this
guide have been prepared to assist you to
understand some of the dilemmas facing farmers and
ways that these problems can be addressed
 An overview of the main economic concepts and
principles follows
Maximization of profit or satisfaction
Variable and fixed inputs
The margin
Diminishing marginal returns
Substitution
Opportunity cost
Efficiency: return to scarce resources
Comparative advantage
Economies of scale
Supply and demand
Elasticity
Farm profit
Net farm family income
Optimum level of output
Cash flow
Depreciation
Salvage value
Return on capital
Risk
Elasticity
Farm profit
Net farm family income
Optimum level of output
Cash flow
Depreciation
Salvage value
Return on capital
Risk
Maximization of profit or satisfaction
It is generally assumed that farm businesses are
planned for the maximum profit consistent with good
husbandry.
However, when objectives other than profit
maximization are considered, such as the satisfaction of
family interests, reduction of risks, or increased leisure,
which might reduce the potential profit, the costs of
meeting these objectives also need to be considered
Economic principles should be used to indicate the best
allocation of resources for attaining the chosen
objectives.
Variable and fixed inputs
The distinction of farm resources between variable and fixed
inputs underlies much of the economic thinking about farm
production
Variable inputs are those that change with the amount of
output over a given period (e.g. fertilizer, seeds, pesticides,
fuel, harvest, labour)
Fixed inputs are those that remain the same regardless of
the volume of the output actually achieved (e.g. land rent,
labour required for cultivation irrespective of final yield,
livestock, tools, machinery, buildings)
The same distinction lies between costs that vary with output
and fixed costs that are incurred irrespective of the level of
output.
The margin
This is the added output, input or value (cost of product).
It is measured either in physical (production) or financial
terms
The marginal product per unit of input reflects to
the yield added to the total production by adding one more
unit of input
Similarly, the marginal value of production
refers to the value added to the total value of production by
adding one more unit of input
Other common marginal terms include: marginal input and
marginal cost, which refer respectively to added inputs and
the value of an added input.
Diminishing marginal returns

The principle of diminishing marginal physical and

financial returns is vital to understanding farm
production economics
It is the use of the concept of diminishing returns
that determines the best level for any production
practice or activity on the farm.
Substitution

The principle of substitution applies whenever farm

output can be produced by different combinations of
inputs or different methods of production.
Opportunity cost

This principle notes that by transferring resources

from one activity to another there is a cost that is
often not measured
This is the income lost as a result of reducing
the level of output from which resources are
withdrawn
The strict definition of opportunity cost is the
maximum income that the resource(s) could have
given in an alternative use.
Efficiency: return to scarce resources

Farm efficiency is concerned with the wise use of

the resources available to the farmer
One way to look at efficiency is from the point of
view of the factors of production (i.e. natural
resources, labour and capital).
In most cases, one of these factors will be the one
that limits profits the most
This is the most limiting factor or the effective
resource constraint.
Comparative advantage

This principle refers to the distribution of physical

resources, over space
That is, the best use of land in different locations for
the production of different crops and livestock
It suggests that for greatest efficiency farm activities
should take place in those locations where the factors
of production (climate, soils, terrain, labour
availability) provide advantages of the lowest costs
compared with other sites
Economies of scale

Economies of scale are achieved when the cost per

unit of production or output marketed is reduced as
the scale of the activity increases
Savings (economies) can be achieved by spreading
costs over a larger scale of operation
Economies of scale can also be achieved among
farmers when they organize themselves into groups
to buy inputs, obtain capital or market produce.
Supply and demand

A market exists when buyers wanting to exchange

money for goods or services are in contact with
sellers wanting to exchange products or services for
money
A market is made up of people who use, need or
want a product and who have the money to buy it.
Prices are set by producers and consumers coming
together to exchange goods and services.
Elasticity

This is an economic concept that explains changes

in product prices, supply and demand.
It explains why the prices and quantities of some
products supplied and demanded can vary more
significantly than others
When the price of a product changes, the supply
and demand for that product also change
The degree of change in the demand and supply in
response to a change in price is called elasticity.
Different products have different elasticities.
Farm profit

Farm profit refers to the money left over after

paying for the variable and fixed costs
If the difference is positive, that farmer is making a
profit; if the difference is negative the farmer is
making a loss.
Net farm family income

Net farm family income is a concept that takes into

account the value of family labour in calculating profit.
The cost of family labour is done by valuing what it
would cost to hire that labour instead of using it in
production
After farm profit is calculated, family labour costs
are deducted.
Optimum level of output

This concept explains how much of each resource

a farmer should apply
The decision is based on the comparison of the
costs and returns
The point of optimum level of output is where the
value of the marginal product is just sufficient to
cover the cost of the resources used.
Cash flow

Cash flow is a concept used to assess if the farmer

has sufficient money available to make changes to
the farming system
This may involve a change in farm enterprise
composition or alternatively purchasing a capital
asset, as examples
The cash flow enables the farmer to identify the
time of the year when additional financial resources
may be required.
It is made up of the flow of money that comes into
the farm from sales and the flow of money that leaves
the farm through purchases and expenditures
The net cash flow is the difference between the
cash inflows and outflows
The cash flow can help the farmer determine the
financial performance of the farm as a whole.
Depreciation

Depreciation is a concept used to assess the loss

of value of an asset over time
This occurs as a result of the asset being used or
because it eventually becomes obsolete
As time proceeds there will always be a need
to replace an asset.
Salvage value

Assets have a given life expectancy

The concept of salvage value expresses the value
of an asset that is unused at the time that it is sold.
Return on capital

Return on capital is a concept used in economics to

decide whether or not to buy a fixed asset such as
machinery, equipment, an animal or establish a tree
crop.
These are all long term investments
The return on capital expresses the profit expected
from the investment related to the capital required
It is expressed as a percentage rate of return on the
cost of capital.
Risk

The concept of risk reflects the fact that future

events cannot be known with complete certainty
Risk occurs when the outcome of a decision is not
known in advance or cannot always be predicted.
These risks need to be taken into account by
farmers when making decisions.
 Glossary

Assets - Items of capital owned by the farmer.

Capital - Items produced as a result of “human

effort”.

Cash flow - The flow of money into the farm from

sales and the flow of money out of the farm through
purchases.
Competitive enterprises - Farm enterprises for
which the output level of one can be increased only
by decreasing the output level of the other.

Complementary enterprises - Enterprises for which

increasing the output level of one also increases
the output level of the other.

Cost of capital - Payment of interest for capital

investments.
Demand - The amount buyers are willing to buy at a
particular price.

Depreciation - The loss of value of an asset over

time, either because it is being used or because it will
eventually become obsolete.

Efficiency - The wise use of the resources available

to the farmer.
Factors of production - The resources needed for
production.

Farm enterprises - The range of products produced

on a farm.

Farm profit - The money left after the variable

costs and the fixed costs have been paid.

Fixed costs - Costs that do not vary with changes in

production.
Gross margin - A measure of what the enterprise
is adding to farm profits. The gross margin for a crop
or livestock product is obtained by subtracting the
variable costs from the value of production.

Inputs - Items that are used for production.

Investment - Money used to purchase a capital

item that provides future benefits.

Labour - The work of farmers, their family and hired

labourers; human effort.
Market - A place where the exchange of products for
money takes place.

Market price - The price that both the buyer and

the seller are willing to accept for the product that is
being exchanged for money.

Marketing - A process by which produce produced

by farmers reaches consumers.

Natural resources - “Gifts of nature”, including land,

water, soil and rainfall.
Net farm family income - The net farm income after
taking into account the cost of family labour used to
generate it.

Opportunity cost - The income that could be

received by employing a resource in its most
profitable alternative use.

Outputs - The crops and livestock produced.

Production function - The relationship between

inputs and outputs.
Rate of return - The increase in profit as a percentage of the
capital cost of the investment required to increase the profit.

Risk - A situation in which more than one possible outcome

exists, some of which may be unfavourable.

Salvage value - The market value of a depreciable

asset at the time it is sold or removed from service.

Supplementary enterprises - Farm enterprises that use

resources that might otherwise not be used “supplement” one
another. An example of a supplementary enterprise is
intensive livestock such as poultry or pig – that has no
significant demand on land as a resource.
Supply - The amount that farmers are prepared to sell at
a particular price.

Value of production - The money received from the sale

of produce together with the value of produce that is
consumed and stored.

Variable costs - Costs that vary according to the size of

an enterprise and the amount of inputs used.

Working capital - Working capital consists of the money

needed to buy stocks of inputs and materials and items of
expenditure paid in advance of income earned.